Does Emerging Market Debt have further to run?

What do Angola, Iraq and Ecuador all have in common? According to us, they’re all part of a handful of countries whose bonds are tipped to outperform as the global economy reflates. And while US rates continue to rise, hurting countries sensitive to higher yields, a weaker dollar and stronger growth should provide a favourable backdrop for emerging market bonds in 2018.

Emerging market debt has been in demand, especially with stable currencies, global growth, and a commodity rebound that began in 2016.

Moreover, the past few years have actually seen a string of credit upgrades to countries like Indonesia and Argentina after years of downgrades. Credit quality is improving overall, so we remain constructive.

Energy and reform stories

Other countries set to benefit from reflation include Brazil and Kazakstan, two notable overweights among the Candriam EMD funds, as oil and commodity prices continue their ascent.

We have been playing the commodity complex rebound for some time, although we still think it has further to run given the pickup in global growth and the depressed prices before.

Elsewhere, we favour countries enjoying reform stories.

We are overweight high yielders with structural reform momentum or IMF programmes, such as Argentina, Egypt and Ukraine, as well as select Eastern European credits where valuations appear attractive. All three countries have turned the page after years of turmoil, attracting foreign investors amid a series of re-ratings.

So if Argentina and Angola are in, which countries are out?

We are underweight low beta, US treasury sensitive credits with tight valuations. This includes Peru, the Phillipines, Poland and Panama, most of which are yielding around 4% and offer a smaller spread over treasuries. We also aim to hold a low exposure to South Africa, which is suffering from tight valuations, domestic political transition, downgrade risks and weak growth.

The underperformance of treasury sensitive credits highlights the growing headwinds now facing fixed income investors in developing countries, with bond luminaries such as Bill Gross and Jeff Gundlach calling an end to the 30-year bond bull market.

Keeping it local

The same can’t be said for local currency bonds, which continue to go from strength to strength. Inflation has bottomed.

EM currencies have been deeply depressed, meaning currencies such as the Chilean Peso, Colombian Peso, Malaysian Ringgit and Russian Ruble all look attractive after years of selling off.

What’s more, the market is underestimating how long regional central banks can keep rates low for. Unlike in Europe, the US and Japan, countries like Brazil and Russia still have further room for rate cuts, which will support fixed income assets there.

This carry trade, a strategy whereby investors bet on better returns and currency appreciation in other countries, should be aided by a weaker dollar too. Although the dollar fell sharply against most currencies in 2017, we see further room for depreciation going forward, boosting local bonds.

While extreme positioning suggests that a dollar bounce could be on the cards in the near term, this is likely to be brief. What matters is the twin deficits, which are ballooning as a result of tax cuts and a potential infrastructure package. This is probably going to be a long-term, multi-year trend which should boost global liquidity, trade and Emerging Market debt.